Thoughts on “Hayekian Insights for Trying Economic Times”

Following a recent panel at the Cato Institute commemorating the publication of a new edition of F.A. Hayek’s The Constitution of Liberty, Arnold Kling brought to my attention a recent essay on Hayek by Bruce Caldwell. On the panel, Caldwell provided a thorough and concise refutation of George Soros’s blatant misreading of Hayek. Naturally, I sought Caldwell's essay out.

In this work, “Ten (Mostly) Hayekian Insights for Trying Economic Times,” Caldwell seeks to “identify 10 key themes to be found in the writings of Hayek and others in the tradition to which he belonged that may provide some insights into how we might respond to the current dilemmas that we face.” The essay is thought-provoking, and several points are worthy of further discussion.

Theme #1: The business cycle is a necessary and unavoidable concomitant of a free-market money-using economy.

Caldwell cites Austrian business cycle theory to proffer an explanation of the recent financial crisis:

Hayek’s theory offers a pretty good description of at least part of what happened in the latest meltdown, especially in terms of the Federal Reserve’s interest rate policy and its effects on the housing sector. In Hayek’s theory, problems start when the market rate of interest is held too low for too long. This always politically popular policy leads to malinvestment — too many investment projects get started that cannot ultimately be sustained. When people realize what has happened, investment spending collapses and a recession begins. The dangers of a prolonged low-interest-rate regime in distorting how the various factors of production in the economy are allocated — what the Austrians call the structure of production — is something to take away from the theory, especially given the political popularity of such a policy.

My understanding of the Austrian business cycle theory is the same as Caldwell’s, but I characterize it a bit differently. As I understand it, a fiat monetary system creates money and then disperses it via banks — in the U.S., the 12 regional Fed banks — to selected customers and then out to the rest of the economy. When the flow waxes or wanes, the wave crests, and troughs move over various segments of the public, leading to higher or lower investment and consumption.

These monetary phenomena may not accord with the underlying realities of consumer demands. That mismatch can beget over- or underinvestment, thus creating a bubble and then the inevitable collapse. Commodity markets have evolved many mechanisms to reduce the severity of such fluctuations — including hedging, stockpiling, and alternative technologies.

Would a competitive money supply reduce the business cycle problem in a similar fashion? I recognize that the idea may be viewed as radical, but then many classical liberal concepts are seen as radical in our illiberal political environment.

Theme #2: The 1970s show why Keynesian economics was rejected.

In the late 1960s and 1970s, Keynesian policies created their own backlash — a consequence of the economic calamities they begat.

When inflation began to appear in the late 1960s due to LBJ’s deficits, a precisely calibrated income tax surcharge designed to tamp down demand was imposed. Yet because it was viewed as temporary, it had no effect, and inflation continued to rise. This was the first signal that the machine metaphor might have been the wrong one.

Things got much worse in the 1970s as inflation turned into stagflation. The main lesson of the 1970s was that once inflation gets started, it is very difficult to get rid of it. To fight it, the government has to tighten up the economy. This in turn induces unemployment, and because the effect on inflation is not immediate, for a time both the unemployment rate and the inflation rate go up together.

Sadly, Keynesian economics was not rejected for long. We’re all Keynesians again — falling prey to government “stimulus” and scientistic fallacies. Government doesn’t need to “prime the pump.” Rather, we need a deregulatory stimulus to free the nation’s creative economic forces. As Wayne Crews, CEI’s vice president for policy, puts it:You don’t need to teach the grass to grow; simply move the rocks off of it!

Theme #3: Some regulation is necessary . . .

The comment by Caldwell that I most enjoyed at the Cato forum was his citing of Hayek’s response to Wassily Leontief’s furious attack on him, which essentially boiled down to, “How dare you criticize planning!” Hayek’s answer was that the question was not whether to plan or not, but rather, Who should plan for whom.

In his essay, Caldwell defines this distinction: “The sort of planning that Hayek favored was a general system of rules, one that would best enable individuals to carry out their own plans.” He adds, “For markets to work effectively, they must be embedded in a set of complementary social institutions.” Indeed, the regulatory disciplines of a competitive marketplace are generally far more effective than the regulatory disciplines of a politicized bureaucracy.

Theme #4: . . . but a lot of regulation is fraught with problems and will make matters worse.

Caldwell makes an important point about the speed and wisdom of bureaucrats:

The basic Austrian insight here is that entrepreneurs (including those who realize there is money to be made from devising ways of getting around regulations) are always forward-looking, while regulators and legislators are almost of necessity backward-looking.

While there might be a handful of individuals knowledgeable in the complexities of financial engineering, the likelihood that such individuals will find employment in a federal regulatory agency satisfying is nil.

And even if such wise individuals existed and were willing to toil away in government planning offices, their actions would still be hampered by the fact that no one else would know what they’re up to at any one time, and how long it would be before they would change course.

Regulation also inserts uncertainty. As Hayek put it, “the more the state ‘plans,’ the more difficult planning becomes for the individual.” There was plentiful evidence of this in the recent downturn. In the fall of 2008, each announcement by the Fed and the Department of the Treasury, while meant to reassure the markets, produced more and more panic. It also froze people into inaction. One could imagine the decision-making process that took place in many people’s minds: “Should I hold onto my house that is underwater, in the hopes of a government bailout? Should I buy a car now that the prices are low or wait for some government program that will cause them to fall even lower? A stimulus plan is coming, and I don’t know what it will look like; probably best to delay all decision-making for now, to wait and see.”

Over and over again, we encounter examples of people basing their decisions on trying to guess what the government is going to do. Contrast this with what happens in well-functioning markets, where people make their decisions principally by looking at changes in market prices, prices that reflect underlying scarcities.

Indeed, government bureaucrats have no means to convey information as effectively as prices can.

Theme #5: The economy is an essentially complex phenomenon for which precise forecasting — on which the construction of rational policy depends — is ruled out.

Exactly — and when we put all our eggs in the same basket, the results of errors are magnified. “[T]he things that we actually do know all concern limitations on our knowledge and on our ability to formulate and carry out rational policy,” Caldwell notes; and continues:

This does not mean that policymakers cannot get things right when it comes to managing the economy as a whole. It is just that sometimes stabilization policy stabilizes the economy, and sometimes it destabilizes it, and we usually can’t tell in advance — and sometimes not even in retrospect — which scenario is unfolding or has unfolded.

Theme #6: In any complex social order, any action may have both good and bad unintended consequences.

One reason for optimism is the fact that the term “unintended consequences” has entered the public policy debate. Perhaps the fallacies of central planning are becoming clearer?

The bad side of unintended consequences is that many attempts to impose our will on the complex adaptive system that is the economy cause things to happen that were not part of our original intention. For example, as everyone recognizes, a market system does not satisfy our longings for “social justice.” In response, well-intentioned people — or those with interests who can play on the sentiments of the well-intentioned — naturally seek to make adjustments in a market system so as to produce more desirable results. Unfortunately, time and again, history has demonstrated that . . . all sorts of pernicious effects will occur that were not part of the original intention.

As I’ve argued before, during the Great Depression, people wisely distrusted big business, so they turned to big government — which had never been tried in peacetime — as a more attractive option. Today neither is trusted, which improves the odds for a more realistic comparative assessment of markets vs. government.

Theme #7: Basic economic reasoning captures what we can know and say about the essentially complex phenomenon that we call the economy.

Following Hayek, Caldwell describes the market economy as a mechanism for the efficient allocation of scarce goods. He is pleased that "basic insights about the workings" of the market are now built into economic education:

These tools allow us to talk about the fundamental fact of scarcity, the choices that scarcity makes necessary, the costs of choice, and the ways to push back against scarcity, at which point the notions of the division of labor, specialization, comparative advantage, the productivity of capital, and the gains from trade are introduced. If one adds to these the concepts of elasticity of demand and supply, and some basic intuitions about market structures, one can explain a lot about the world, as anyone who has ever taught an introductory economics course knows.

Here I have some major disagreements. I find the view of economics as a system for efficiently allocating scarce goods, a view that Caldwell seems to favor, overly static. I prefer the Coasian view of the market as a set of institutions for lowering the transaction costs of voluntary exchanges. In this regard, I’m influenced by Joseph Schumpeter, who noted:

A system — any system, economic or other — that at every given point of time fully utilizes its possibilities to the best advantage may yet in the long run be inferior to a system that does so at no given point of time, because the latter’s failure to do so may be a condition for the level or speed of long-run performance.

I recall my own undergraduate one-year course in economics. When presented with the positive-sum nature of exchange driven only by self-interest, I asked, “Why wouldn’t the party that held both items in a given transfer just stop the transaction at that moment?" Most transfers involve a period when one party holds both items and at that (possibly brief) moment, short-term self-interest would entice that party to not complete the transaction and singularly benefit. My professor didn’t understand my concern, and only years later did I come to understand that markets “work” because both parties hope to engage in future transactions. If they default once, they will face either cultural or legal sanctions and will at least find it hard to identify future transaction partners. That is, before a world of voluntary exchanges can occur, institutions (cultural or legal sanctions, an expectation of future exchanges) must exist — institutions that discipline transfers. (In a priori probabilistic terms introduced by Ronald Coase, the transaction costs must have been reduced earlier to make such transfers mutually advantageous.

Of course, when I asked my question, economics professors had no interest in or understanding of the role of institutions in lowering transaction costs, of making markets possible. And often they still don't have that interest or understanding. Most people trying to understand why markets exist are unaware of the evolution of the institutions that make voluntary exchange viable. Naiveté about “markets” has led to “market socialism” and “market mechanisms” and other collectivist beliefs that markets can be created from whole cloth by means of top-down political planning. Consider, for example, the various emission trading systems that are now being proposed. The late Warren Nutter aptly noted: “Markets without property rights are a grand illusion.” He was discussing the mechanical attempts in Russia after the fall of the Iron Curtain to replicate markets, but the principle is true elsewhere.

Unfortunately, modern economics is often based on static equilibrium models designed to be solved rather than to resemble reality. Coase became a nonperson in the economics profession (as did most Austrians), in large part because he kept asking embarrassing questions of this sort.

Theme #8: Demands for social justice can be satisfied.

I believe that this was Hayek’s biggest mistake.

Somewhat controversially in the eyes of certain Austrians and libertarians, Hayek argued that in a society that had reached the general level of wealth that Britain or the US had achieved, “there can be no doubt that some minimum of food, shelter, and clothing, sufficient to preserve health and the capacity to work, can be assured to everybody,” and also that the state should “assist the individuals in providing for those common hazards of life against which, because of their uncertainty, few individuals can make adequate provision.”

Granted, Hayek’s concept of a “safety net” was quite minimal in comparison to that of our modern welfare state, but to argue for it in the first place leads inevitably to unsustainable middle-class entitlements. We may not be able to avoid such policies altogether, but to endorse them is to endorse the instability of the welfare-regulatory state. Hayek struggled with this dilemma; I do not think he ever resolved it. (This may be the reason that, in a previous Cato panel, Richard Epstein argued that Hayek never overcame his social democratic roots.)

Here I agree completely. I consider Hayek's “The Use of Knowledge in Society” the most important essay in economics. The idea embodied in that work was the essence of the market calculus debate between von Mises and Hayek on one side and Lerner, Lange, and Kornai on the other. Caldwell offers a good summation of Hayek’s view.

The question that must be solved in constructing a rational economic order in such a world is: How can we use the knowledge that is dispersed among millions of fallible market agents so as to achieve some level of social coordination and cooperation?

Hayek’s answer was that a market system with freely adjusting market-determined prices is, when embedded within an appropriate institutional structure, a marvelous mechanism for coordinating human action.

Unfortunately, many modern economists — including some self-avowed “free market” economists — have ignored Hayek’s view on this topic, as the vogue for Pigouvian taxes and quotas illustrates.

Theme #10: The basic "public choice" idea is true: more often than not, government cures are not only worse than the disease, but lead to further disease.

I largely agree with Caldwell’s valuation of public choice economics in helping to explain why government grows and rarely recedes.

Public choice theorists believe that politicians, like everyone else, act in their own self-interest. If consumers maximize utility, firms maximize profits, and politicians maximize votes, what do bureaucrats maximize? The answer is troubling: Bureaucrats have an incentive to maximize the size of the bureaucracy under their control.

However, I find that public choice focuses too heavily on economic motivations, without taking other factors into account. Public policy is a two-tier process that includes both economic and ideological interest groups. Public choice thinkers tend to ignore the motivations of the latter, even though their influence is often much greater than that of business people or other economically motivated groups.

Bruce Yandle’s “Baptists and bootleggers” paradigm illustrates how economic and ideological groups often interact to pursue shared agendas. One group — the Baptists — advocates prohibition on moral grounds, while another unrelated group — the bootleggers — profits from the extralegal opportunities created by policies resulting from the former’s moral crusade. There has, however, been too little attention paid to the ideological groups.

Much of publicpolicy is driven by ideological groups crafting narratives that effectively link their favorite policies with core social values. Aaron Wildavsky and Mary Douglas argued that people respond to a policy by a quick decision as to whether that policy advances or threatens their core values. That decision will be influenced by the narratives communicated about policy.

Today’s “Baptists” are often environmental, labor, “consumer,” “human rights” groups advocating government intervention in the economy to advance some feel-good cause. To date, free market advocates have been far less effective than the left in crafting narratives that persuade a majority of people that classical liberal policies advance core values — whether these be equality, fairness, order, or security — better than do statist ones.

In conclusion, I should note two questions that I believe Hayek neglected to explore adequately. The first is: why do so many bad policies evolve and survive? (Granted, Hayek's “The Atavism of Socialism” essay deals with that theme to some extent.) The other question is: how could Hayek's own ideas be implemented? His focus on “What do we know and how do we know it?” was crucial, but more attention to “How do we change it?” would have been valuable.

Hayek did have a change agenda — one I agree with — but he did not clarify sufficiently what we could do to bring that about. His recommendation to fight the war of ideas is necessary, but not sufficient. Still, few others have done as much as Hayek, whose work I consider critical in the battle for the future of civilization.

ldquo;free market

About this AuthorFred Smith is the founder and president of the Competitive Enterprise Institute, a free market public policy group and international NGO in Washington, DC. He addresses complex policy issues ranging from the environment to corporate governance and is a frequent guest on national TV and radio programs, as well as a prolific writer. As a former policy analyst with EPA, he speaks with candor about the true cost of
government regulation.

Comments

Jon Harrison

Very interesting piece. Does the Austrian school anywhere recognize the irrational in human affairs? Economics cannot be reduced to a purely rational "science," because one simply can't quantify irrational behavior with anything like scientific rigor.

Didn't Keynesianism work in the period 1933-36, when unemployment fell from 25% to 11%? The recession of 1937 and the consequent rise in the unemployment rate to 17% were the results of fiscal tightening, were they not? Anti-Keynesians say no, but I've never seen a convincing argument disproving what seem to be a rather obvious facts. What have I missed? Additionally, how do we account for the tremendous performance of the American economy in the quarter century 1940-1965, when Keynesianism was in full flower?

Thu, 2011-09-29 10:40

Mark

If you want to understand the causes of the great depression, perhaps you (JH) should read "A Monetary History of the United States, 1867-1960."

Of special interests to Keynesians should be the depression of 1920-21. Note that the cure, which worked, did not involve any Keynesian "stimulus."

As for your question regarding the "tremendous performance of the economy in the quarter century 1940-1965, when Keynesianism was in full flower," I suggest you begin with the data. US government spending plummeted after WWII, despite the Keynesians' dire warnings of inevitable economic catastrophe.

I cannot fathom how an intelligent individual can look at any data, whether from Japan, the United States, Canada, or Europe, and fail to conclude that Keynesian economics is faulty. This should not be taken as a swipe at your intelligence, as it is abundantly clear you have never looked at any of the data.

Thu, 2011-09-29 15:46

Jon Harrison

Feel free to take a swipe at my intelligence; I don't care what you think of my mind. But if you want to lecture me, try sticking to the points I raised. I didn't ask about the depression of 1920-21. I also didn't ask what caused the Great Depression. What I want to know is why unemployment went from 25% when Roosevelt took office to 11% at beginning of 1937. If it wasn't the result of pump-priming and government make-work jobs, then what was it? And did unemployment rise to 17% after 1937 because of retrenchment on the fiscal front, or not? I was looking for other people's views on these particular issues.

Government spending did plummet briefly after WWII, then picked up again. I don't think anyone disputes that government spending over the entire period 1940-65 was much higher than in any twenty-five year period of our earlier history. I also don't think anyone disputes that, overall, the economy grew strongly with low inflation, especially in the years after Korea. Granted, there was a bout of high inflation in the immediate post-WWII period, and again during the Korean War. But times were very good in the quarter century after 1940.

You've apparently made the assumption that I have a definite opinion on the economics of the 1930s. I'm actually interested in what the author (and anyone else who cares to comment) thinks about the points I raised. How much of the data you think I've examined does nothing to advance the argument, although I daresay commenting in that vein gave you a brief frisson of self-importance.

Thu, 2011-09-29 20:49

Mark

You asked three questions united by a common theme: 1)"Didn't Keynesianism work in the period 1933-36, when unemployment fell from 25% to 11%?", 2) "The recession of 1937 and the consequent rise in the unemployment rate to 17% were the results of [anti-Keynesian] fiscal tightening, were they not?", and 3) "[H]ow do we account for the tremendous performance of the American economy in the quarter century 1940-1965, when Keynesianism was in full flower?" The theme, in case you've missed it, is "Keynesian economics might work." This theme is even more evident when one considers the article to which you were responding, which explicitly addresses "the current dilemmas that we face."

Do you really maintain the repeated failure of Keynesian stimuli is irrelevant to the validity of the Keynesian model? Do you believe that the wildly off-base predictions of the Keynesians after WWII shed no light on the subject? What about the wildly off-base predictions of the Keynesians over the past few years? What about the economic health of other first-world countries? (In case you hadn't realized it, the countries with the most consistent "stimulus" are the countries whose economies are faring worst -- not just today, but as a general rule.)

If more government spending is the fix for what ails us, why are we sick today? Government spending increased in the 70s, increased again in the 80s, increased again in the 90s, and increased yet again from 2000-2009. With all this stimulus, our economy should be roaring along. Certainly if some perfect storm of outside factors caused the economy to stumble, the ever-increasing stimulus must almost immediately put us back on course.

Incidentally, I've made no assumptions about your views on economics. I have, however, noted that your understanding of economics is, at best, faulty.

Thu, 2011-09-29 23:47

Jon Harrison

In my previous reply, I attempted to clarify what I was looking to get people's views on. I asked three specific questions. Whether I'm implying that Keynesianism sometimes works is not relevant to what I'm seeking, which is answers to those three questions. I engaged you once, even though I usually ignore people who don't include their full name when they post. I'd still like to have your your response to those three questions, if you can manage to stay on topic. The rest of what you have to say frankly doesn't interest me.

Fri, 2011-09-30 10:19

Mark

Here are the answers to your questions, and some other pertinent information that frankly, won't interest you:

1)"Didn't Keynesianism work in the period 1933-36, when unemployment fell from 25% to 11%?"

No. First off, your figures are exaggerated. Second, a reduction in the unemployment rate says exactly nothing about the health of the economy. (I can elaborate on this if desired.) Third, correlation is not the same as causation.

That being said, it is possible for a Keynesian stimulus to lead directly to a temporary increase in overall employment.

2) "The recession of 1937 and the consequent rise in the unemployment rate to 17% were the results of [anti-Keynesian] fiscal tightening, were they not?"

No. First off, there was no significant "fiscal tightening in 1937 (nor in any other year in the '30s). Yes, the government spent about 2% less (in constant dollars) in 1937 than in 1936, but 1937 spending was still over 8% higher than that of 1935, and over 20% higher than spending in either 1933 or '34. Second, there were a multitude of confounding factors (notably huge strikes by the AFL and CIO, trust-busting, and FDR's punitive tax increases*).

Federal, state, and local government spending (in billions of 2005 dollars) are shown below.

3) "[H]ow do we account for the tremendous performance of the American economy in the quarter century 1940-1965, when Keynesianism was in full flower?"

I can interpret that question in two ways, so I will give two brief answers.

In the first interpretation, the question implies that Keynesianism was not "in full flower" for the majority of the rest of the 20th century and the entire 21st century to date. Since government spending has steadily increased over the (implied) non-Keynesian period, the question makes no sense. Either a)this is not the correct interpretation of your question, b) you are woefully misinformed about government spending, or c) you define Keynesianism by some criteria that are not closely correlated with government spending. If "c" is the case, please specify your criteria.

In the second interpretation, the question implies that non-Keynesian models are such that government spending necessitates a weak economy. There are in fact no serious models in which this is the case. Government spending -- at least beyond a minimal level -- certainly doesn't help the economy, but neither is it necessarily terribly detrimental. As to what actually produced the strong economy, you may as well expect a short answer to the question "why is that young person healthy?" There is no short answer other than "because he's not sick." The system has evolved to act in a certain manner; in the absence of impediments, it will tend to perform in that manner.

* I am unsure about the exact timing and implementation of FDR's various tax schemes, hence the asterisk on this possible confounding factor.

Fri, 2011-09-30 18:57

Jon Harrison

Thank you for those answers. And I actually was interested in the additional information you provided, particularly as you did try to stay on topic. I was especially interested in your answers to questions one and two; on question three you (in my opinion) shifted the playing field to your own advantage with both of your interpretations. It's clear that I would have to dig deeper to give you a better chance to respond on that particular point. That could conceivably lead to an interesting debate, but much as I might like to see you grapple with the issue, I frankly am too tired and busy to make the effort. That's a reflection on me and not you.

As I'm sure you know, there are trained economists who are not at all persuaded by the arguments you make here. I personally do not have a definite opinion on any of the questions I raised. I think I mentioned early on that the "science" of economics has trouble dealing with the irrationality inherent in human behavior. I have never found any economic theory particularly convincing in the broader sense.

I'm sorry that the exchange became a bit snitty. I do tend to mount a high horse when I encounter someone who's even more pompous than I am.

Sat, 2011-10-01 14:22

Mark

Good article, but I'm curious about your claim that "Coase became a nonperson in the economics profession." Nothing else I've read, and nothing I can find now comports with this statement. Indeed, George Stigler, quoted at http://www.econlib.org/library/Enc/bios/Coase.html, recounts that "We strongly objected to this heresy [the insight that is now known as the "Coase Theorem]. Milton Friedman did most of the talking, as usual. He also did much of the thinking, as usual. In the course of two hours of argument the vote went from twenty against and one for Coase to twenty-one for Coase. What an exhilarating event! I lamented afterward that we had not had the clairvoyance to tape it."
The same econlib article notes that between 1966 and 1980, two of Coase's articles were cited a whopping 830 times.